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The European Central Bank raised its key interest rate by 25 basis points to 4 per cent as expected yesterday to combat inflationary dangers in a strongly expanding economy.

The increase marks a doubling of eurozone rates in 18 months, raising questions in financial markets over how close the ECB may be to ending its rate increases.

But strong ECB warnings on inflation risks have left dealers virtually certain that rates will reach at least 4.25 per cent this year.

At 4 per cent, most economists said ECB rates now were in neutral territory and no longer stimulated economic growth.

They wanted to know whether restraint was needed to control price pressures.

'Could the ECB see a circumstance in the near future that would warrant a firming of policy beyond neutral, where it would have to actively slow down economic growth?' said Holger Schmieding, European economist at Bank of America.

At its news conference after the rate rise, the ECB raised its forecast for eurozone inflation this year but left its central prediction for next year unchanged, suggesting further monetary tightening to come.

ECB staff also lifted their expectations for economic growth in the 13-nation region this year despite the central bank lifting interest rates to their highest level in almost six years.

The midpoint of the staff inflation forecast range for this year was increased to 2 per cent from the 1.8 per cent seen in March, marginally above the ECB's benchmark of below but close to 2 per cent. Inflation was seen between 1.8 and 2.2 per cent this year, compared with 1.5 to 2.1 per cent three months ago.

New staff projections put the Harmonised Index of Consumer Inflation for next year in a 1.4 to 2.6 per cent range, giving a midpoint of 2 per cent, the same as in its March forecasts.

'Risks to the outlook for price stability remain to the upside,' ECB president Jean-Claude Trichet said.

Growth in the 13-nation region was seen at 2.3 to 2.9 per cent this year for a midpoint of 2.6 per cent and 1.8 to 2.8 per cent next year for a 2.3 per cent midpoint.

Three months ago, ECB staff saw economic growth of about 2.5 per cent this year and 2.4 per cent next year.

The projections are based on market expectations of future interest rates, which had forecast further ECB rate tightening later this year.

Eurozone government debt held near multi-year highs while the currency was little changed on the rate decision. The euro already gave up some early gains and was trading about US$1.3518, down about a quarter of a cent on the day.

Investors had widely expected the rate rise as business activity was expanding robustly, confidence was high and unemployment was at its lowest level on record, which brightened prospects for consumer spending to surge.

This favours gross domestic product growth this year at 2.5 per cent or higher after 2.8 per cent last year, its fastest pace this decade. The threat is rising that businesses will run out of operating capacity and start pushing up prices.

But uncertainties over the resilience of the global economy to a housing-driven downturn in the United States and a shaky Chinese stock market cast doubt over how quickly the ECB will proceed.

'We have some conflicting signals,' said Marco Valli from Unicredit MIB. 'On the one hand, monetary policy is still on the accommodative side and there was the recall to firm and timely action which is a clear signal of further action in coming months.

'On the other hand, the staff forecasts were a touch more dovish than expected. GDP was revised up only marginally in 2007 and taken down in 2008.'

Mr Valli predicted another quarter percentage rate rise in September and another in December.

'He is clearly signalling that they haven't finished. They talk about monetary policy still being accommodative at 4 per cent and it looks like they still see inflation risks to the upside,' said Tom Vosa, head of market economics at NAB Capital.

'I doubt they are in a hurry to tighten, it doesn't look as though they are increasing the pace.'

Risks to the outlook for price stability remain to the upside
Jean-Claude Trichet,
president, ECB